February Economic Commentary: Early Year Job Growth Reports Deal the Market a Surprise

2023 ended on a stronger economic note than expected according to data reported during the past month. Despite the Fed’s tightest monetary policy in 40 years, a strong labor market and easing inflationary pressures have enabled real (inflation-adjusted) disposable personal income to grow at the fastest yearly pace since 2020 and provide ongoing support for the economy. Interest rates have likely peaked, but there is little urgency for the Fed to start cutting rates until they see a more substantial slowdown in the economy and sustained easing of inflationary pressures.

CPI, Consumer Spending & Lending

The Consumer Price Index (CPI) for December came in a little hotter than consensus, indicating that the path to the Fed’s target of 2.0% may take a bit longer than expected. Headline CPI increased 3.4% year-over-year from 3.1% in November, while year-over-year core CPI eased to 3.9% from 4.0%. More importantly, the Fed’s preferred measure for inflation, the Personal Consumption Expenditure Index (PCE), showed that inflation increased 2.6% year-over-year, and the core PCE eased to a 2.9% year-over-year rate from 3.2%. On a three-month and six-month annualized basis, the core PCE is growing at less than the 2.0% Fed target.

As mentioned above, consumer spending was supported by incomes growing faster than inflation. Additionally, consumers have been using savings, credit cards, and buy-now/pay-later borrowing so that personal spending was greater than personal income during the second half of 2023 by about 20%. Consequently, the savings rate is now down to 3.7% - the lowest level for the year 2023. Credit card balances increased at the fastest year-over-year rate on record according to the New York Fed. Unpaid balances on credit cards have surpassed 2019 levels, and consumers are taking longer to pay off their bills than before the pandemic.

Bank lending continues to slow, with total loans and leases at all commercial banks only growing 1.9% year-over-year compared with an 11.4% growth rate at the end of 2022. Loan loss provisions from the six biggest banks increased to $9.3 billion in fourth quarter 2023, representing a 30% year-over-year uptick. The top 25 banks are approaching $50 billion in loan loss provisions, which is the most since fourth quarter 2020. Among the most frequently cited reasons banks expect to maintain tight lending standards are less favorable or a more uncertain economic outlook, expected deterioration in collateral values, and the credit quality of loans.

Leading Economic Indicators & GDP Growth

At the risk of sounding like a broken record, leading economic indicators declined for the twenty-first consecutive month in December. The biggest drags came from consumer expectations and manufacturing new orders.

The advance report of fourth quarter 2023’s real GDP provided surprising evidence of economic strength with an increase of 3.3% (annualized rate) bringing real GDP growth in 2023 to 2.5%. There was stronger than expected growth across all the major subcomponents of the report including personal consumption, investment, and government. Despite the strong end to 2023, real GDP is forecast to only grow about 1.0% annualized in the first half of 2024.

The Labor Market

The employment report for January provided the biggest surprise of all the reports. Job growth in January was 353,000 – nearly twice the consensus forecast – and December’s employment numbers were revised sharply upward indicating an acceleration in job gains. Gains in employment were more broadly based than seen in recent monthly reports. The unemployment rate was unchanged at 3.7%.

Two areas of concern in the otherwise strong employment report were average hourly earnings (+0.6%) and the reduction in the average workweek from 34.3 hours to 34.1 hours. The unfavorable readings in these metrics can likely be tied to the inclement weather in January which particularly impacted employees at the lower end of the wage scale. Those workers were often unable to work due to the weather and the impact of their lower wages were left out of the calculation of the average hourly earnings. Additionally, an increase in the minimum wage became effective in 22 states.

Mitigating the uptick in the growth of hourly earnings was an earlier report that showed strong labor productivity in fourth quarter 2023 at +3.2% (+2.7% year-over-year) and a small increase in unit labor costs of +0.5% (+2.3% year-over-year). Both are supportive of easing inflation pressures.

The Employment Cost Index (ECI) for fourth quarter 2023 – the Fed’s preferred measure of labor cost pressures – was up 0.9% (+4.2% year-over-year), which was the best quarterly reading since second quarter 2021. The Fed is looking for the year-over-year ECI to move to 3.5% which, together with a long-term increase in productivity of 1.5%, would be consistent with their 2.0% inflation target.

Inflation & Interest Rates

The Fed kept the target Fed Funds rate unchanged (5.25% - 5.50%) for a fourth straight meeting while pushing back against an interest rate cut in March, noting that it “does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.” Concern was expressed about continued easing in financial conditions, with stocks up and credit spreads tight, that could boost demand, and tight labor markets that could keep prices for services moving higher.

The real (inflation adjusted) Fed Funds rate is now at the highest and most restrictive level since 2009. Even if the Fed does not increase rates any further, declining inflation pressures will effectively cause the real Fed Funds rate to increase – a form of passive tightening.

Markets are pricing in four to five cuts in interest rates beginning in May or June while the recent forecast from the Fed only calls for three cuts by year-end. The pace of lowering interest rates by the Fed will likely be dictated by the strength of the labor market. Due to their dual mandate of price stability and full employment, if weakness in the labor market develops, the Fed would likely need to respond more aggressively with faster interest rate reductions.